December 2017 - The Pillars of Volatility
Updated: Jul 10, 2018
As we move into the final month of the year, 2017 is looking like one of, if not the least volatile years for the vast majority of asset classes. For the S&P 500, it has been more than 350 days since a 5% correction or more, the longest streak since 1929. What’s more, November 2017 marked the 13th consecutive month of positive total returns for U.S. stocks, their longest streak ever. With less than one month before we turn the calendar, it is worth reflecting on what has accounted for this year’s record-low level of volatility and strong market returns with the MSCI All-Country World Index up 21%.
In our view, there are three main contributors to this low volatility environment. The first consists of the synchronized global expansion which began in mid-2016 in which growth is running above trend for both developed and emerging market economies. According to the International Monetary Fund, which estimates 2017 global real GDP growth of 3.6% from 3.2% in 2016, 75% of the globe is experiencing positive economic growth with the fewest number of countries experiencing recession in a decade. Recent high-frequency data confirms the strength of the current cyclical upswing. The J.P. Morgan Global Composite PMI, which has not fallen below 53 all year, currently stands at 54, its highest level since the index peaked in March 2015. While readings are strong across regions, Europe has demonstrated particular strength, with its composite PMI at 57.5, a 79-month high. The consistency of the recent incoming economic data has translated into lower financial market volatility.
Second, inflation is in a “goldilocks scenario” of being neither too high nor too low. This has produced record low readings in implied bond market volatility as the volatility of core inflation readings in the U.S. reside near historic lows. According to Deutsche Bank, global inflation, especially in the U.S., is in a “sweet spot” where it is strong enough from the lows of 2015 to price out deflation, but is significantly below central bank targets to ensure the continuation of policy liquidity, range-bound bond yields, and easy financial conditions.
Third, central bank liquidity has been its most accommodative since the depths of the financial crisis. According to Bank of America, G4 central banks (U.S., EU, UK, Japan) have added close to $2 trillion to their balance sheets in 2017 which now stand at $14.9 trillion. The continued purchase of assets has furthered the search for yield dynamic and provided a strong psychological support to markets.
The gains which this dynamic has produced continued through November with the MSCI All-Country World Index up 1.4%, its 13th consecutive monthly gain. Developed market equities gained 1.4% versus a 0.9% decline across emerging markets according to MSCI indices. Through the year, emerging market equities are still up 11.4% versus their developed market peers given double digit corporate earnings growth, a managed transition in China’s deleveraging, easy financial conditions and a weaker U.S Dollar which has depreciated 9.25% on a trade-weighted basis.
The S&P 500, which gained 2.5% in November, provided the best monthly returns across developed markets. U.S. financials drove the strong performance into month’s end, gaining 4.9% in the last three days given progress surrounding tax reform, which culminated in the Senate’s passage of a tax bill on December 2. The bill still needs to be reconciled with the House’s version but is likely to produce a cut in the corporate tax rate from 35% to around 20%. It remains to be seen when this cut will actually take place and its impact on the federal budget deficit. In the near-term, this development is likely to boost U.S. equities given its impact on corporate earnings, especially among U.S. domestic small caps which face a higher tax liability than their multinational large cap counterparts.
Credit markets took a bit of a pause on the month despite a benign rate environment where the U.S. 10-year Treasury yield rose just three basis points to 2.4%. More attention has been given to the steady flattening of the U.S. yield curve in which short end rates are moving higher than the longer end, suggesting more muted expectations for growth as the Fed continues to normalize interest rates with another 25-basis point hike expected at its next meeting on December 12. While an inverted yield curve would cause us to be more cautious on risk assets, at 59 basis points we believe the spread between the U.S. 10-year and 2-year yield is fairly normal given the Fed’s rate hiking cycle and low long-end yields outside the U.S.
Within credit, U.S. investment grade returned 0.25% to be up 6.2% on the year while high-yield lost 0.3% to be up 7.2% according to the ICE Bank of America Merrill Lynch (BoAML) Index. The weakness in high-yield was driven mainly by losses across the telecom and cable and satellite sectors, as opposed to a broad asset class sell-off. That said, investors may also have been in profit-taking mode given the extent to which spreads have compressed over the year. With high yield spreads at 363 basis points according to BoAML, just 28 basis points above their cycle low recorded in 2014, we believe returns going forward will be driven more by coupon than spread tightening but should be supported into 2018 by low default rates and an improvement in earnings.
While we expect risk assets to be supported going into 2018, we recognize the withdrawal of central bank liquidity, whether by the Federal Reserve through the normalization of its balance sheet or the tapering of assets purchased by the European Central Bank and a reduction in bond buying by the Bank of Japan, could result in higher volatility 2018. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.